Link to special CCH Tax Briefings on key topics from 2003:
 

• Year-End Tax Legislation Update (Dec. 10)
• Corporate Income Tax and 'Bonus' Depreciation
  (Dec. 4)
• Military Family Tax Relief Act (Nov. 11)
• Jobs and Growth Tax Relief Reconciliation Act of 2003 (May 28)

CCH can assist you with stories, including interviews with CCH subject experts. Also, the CCH Whole Ball of Tax 2004 is available in print. Please contact:
 
Leslie Bonacum
(847) 267-7153
mediahelp@cch.com
 
Neil Allen
(847) 267-2179
allenn@cch.com

Capital Gains Rates Shrink, Schedule D Expands

(RIVERWOODS, ILL., January 2004) – This tax season, many investors will find they benefit from lower tax rates on capital gains and dividends, but they also will pay a price as they fill out this year’s tax forms, according to CCH INCORPORATED (CCH), a leading provider of tax law information and software.

As has happened in the past, a mid-year change in the tax law is responsible for extra work on tax returns. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the rate for long-term capital gains to 15 percent for taxpayers in the 25-percent and higher tax brackets and to 5 percent for those in the 10- and 15-percent brackets for transactions taking place after May 5, 2003. If long-term gains were realized on or before May 5, 2003, they are subject to the old rates of 20 percent for those in the 25-percent and above tax brackets and 10 percent for those in the 10- and 15-percent tax brackets. The 15-percent rate will be in effect through 2008. The 5-percent rate will drop to zero in 2008. Then, in 2009, the rates will rise to their previous 20- and 10-percent levels.

Because of the new law, Schedule D, used to report capital gains and losses, has expanded. Where the first section of the 2002 version had six columns marching across the page, the 2003 form has seven, so that pre- and post-May 5 gains can be tallied separately. The number of lines has ballooned from 40 to 53 to allow separate calculations for the pre- and post-May 5 rates, even after some calculations done on the schedule itself last year have been moved to a worksheet to make more room.

Much of the extra work built into the 2003 Schedule D should disappear on 2004 returns, when a single set of long-term rates should apply to all transactions during the year and when a special, quirky 8-percent rate will no longer apply. But wise investors should pay attention not to the number of lines on the form, but to what it tells them about their taxes and opportunities for tax savings.

Timing, Tracking, Key to Savings

"Timing is half the game in making sure that taxes take a minimal bite from investment income. The other half is in being able to identify and track specific ‘tax lots’ of shares of stock or in mutual funds that you buy and sell," said Cameron Routh, CCH GainsKeeper market development manager. CCH GainsKeeper is the leading provider of automated tax-based financial tools and services for the investment community (www.gainskeeper.com).

For example, consider an investor in the 33-percent tax bracket trying to decide whether to sell 100 shares in Stock A that she purchased nine months ago or 100 shares of Stock B she purchased two years ago, when both are going to generate a gain of $5,000.

She will find the amount she actually keeps is quite different depending on which stock she sells. Selling Stock A would result in a short-term gain, taxed at her 33-percent ordinary income level, for a total tax of $1,650, while selling Stock B would create a long-term gain taxed at the capital gains rate of just 15 percent – a total tax of just $750.

Taxpayers who take the extra effort – or who use special software – to track each individual lot of shares that they add to their portfolios can use that information to identify the tax-lots most advantageous to sell, a technique known as the specific ID method. In the absence of an election by the taxpayer, the IRS will insist on using the first-in-first-out or "FIFO" method for stocks and mutual funds.

The specific ID method can make a difference. Suppose that in December 2001 you invested $10,000 in shares of XYZ Company, then selling at $25 per share. In August 2002, you purchased $5,000 more shares at $50 per share. In June 2004, with the share price now at $55, you decide you want to sell 100 shares. Also suppose that you’re in the 25-percent income tax bracket.

If FIFO is used, it would assume that you had sold 100 of the first shares you’d bought. Your cost basis was $25 a share and you sold 100 shares for $55 each, realizing a $3,000 gain ($55 less $25 times 100).

Because you held the investment for longer than 12 months, it’s taxed at the 15-percent long-term capital gains rates if you’re in the 25-percent income tax bracket, meaning your tax on the $3,000 is $450.

However, if you had indicated to sell 100 shares from the tax-lot you purchased in August 2002 with a basis of $50 per share, you would only have realized a gain of $5 per share for a total capital gains tax of just $75 ($55 less $50 times 100) versus $450.

Unless they notify their fund company prior to selling shares, mutual fund investors must also use the FIFO method. Many elect to use the average cost method, which uses a single average price for all the shares held, simply because it’s easy to use.

But by definition, average cost is a poor method for tax efficiency, precisely because it doesn’t identify individual tax lots that would maximize or minimize tax consequences. By using specific ID, an investor has greater control over tax liabilities and after-tax performance.

"You not only have to keep track of each lot you buy, you have to communicate to your broker or mutual fund company precisely which lot you want to sell ahead of time," noted Mark Luscombe, JD, CPA and principal federal tax analyst for CCH. "You can’t wait until it’s time to do your taxes to decide which lot you actually sold."

Wash Sale Traps

Timing also is key to avoiding a wash sale – trading activity in which someone sells shares of a security at a loss and within 30 days before or after that sale purchases a substantially identical security.

With a wash sale, the loss is deferred for tax purposes, and the deferred loss is offset with a wash sale cost adjustment on the newly acquired tax lot.

For example, say you sold 200 shares of DEF Company for a total of $4,000 on November 18, 2004. Your cost basis was $4,400, so you have a loss of $400. Ordinarily, you could use this loss to offset other capital gains or ordinary income.

If you are aware of the wash sales rule, you wouldn’t intentionally purchase shares of DEF stock on the open market within the 60-day window from October 19 through December 18 that would trigger the wash sale rule and deprive you of this tax-saving opportunity.

But you may find that you’ve inadvertently violated the rule if you participate in an automatic dividend reinvestment plan, or DRIP, which plows dividends back into shares of the same stock.

Suppose, for example, on December 15, your DRIP automatically purchases 100 new shares of DEF at $25 per share. Because the repurchase happened within 30 days of the initial sale, you have a wash sale situation, meaning that you can’t immediately realize the $400 loss from the original sale.

Instead, you adjust the cost basis for the 100 new shares to include the $400 loss. So the adjusted basis for the new 100 shares is the purchase price of $2,500 for the 100 new shares plus $400 for the wash sale, or $2,900. This will lower your gain, or produce a larger loss, when you finally dispose of the stock, but until then, the loss cannot be realized for tax purposes.

"Reinvestment plans are a great way to accumulate extra shares, but they lead to numerous tax lots that must be taken into account when your purpose in selling is to use the loss in the near future," Routh noted.

Dividends Bring New Rewards

Dividends, which for years have been treated the same as ordinary income, now share many of the characteristics of long-term capital gains, and with dividends, as with capital gains, timing is now crucial. To qualify for the same low rates on dividends as on long-term capital gains, investors must hold the underlying stock for 61 days or more out of the 121 days that begin 60 days before the ex-dividend date. This complicated rule is to prevent investors from reaping a double tax benefit, according to Luscombe.

"Shares usually increase in price in advance of a dividend payout and decrease in price after the ex-dividend date to reflect the fact the dividend is no longer available," Luscombe explained. "Without the rule, someone could buy a stock just before the ex-dividend date, then sell it soon after, and benefit both from the low tax rate on the dividend income and a capital loss of up to $3,000 on the sale being taken against that year’s ordinary income."

The question of just when something called a dividend is actually a "qualifying dividend" that can receive favored treatment is far from simple. Cooperatives and real estate investment trusts issue "dividends," but these payments don’t qualify. Most dividends on preferred stock are not "qualifying dividends" – they’re actually considered interest – but some are. Dividends paid by foreign corporations can qualify, but some can’t.

For 2003 taxes, it seems that the IRS will go lightly on taxpayers who rely on the way that dividend payors characterize the payments on the Form 1099-DIVs they send out. It has issued official guidance on 1099-DIVs for foreign corporations, saying investors can accept 1099-DIVs reporting these payments as qualified at face value "unless the individual knows or has reason to know" that the dividend didn’t satisfy the rules.

"Until the IRS says otherwise, I suspect people will take all Form 1099-DIVs at face value, including the ones from mutual funds, for which there is no guidance," Luscombe said.

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served more than four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, accounting, legal, securities and small business markets. CCH GainsKeeper (www.gainskeeper.com) based in Quincy, Mass., is the leading provider of automated tax-based financial tools and services for the investment community and is a division of CCH. CCH is a Wolters Kluwer company. The CCH Federal and State Tax group, CCH Tax Compliance and Aspen Publishers Tax and Accounting group comprise the new Wolters Kluwer Tax and Accounting unit. The unit’s web site can be accessed at tax.cchgroup.com.

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